After Georgia’s national currency, the Lari (GEL), saw a significant decrease in value beginning in late 2014, the monetary policy of the National Bank of Georgia (NBG) became one of the main subjects of criticism from the Georgian government and parliamentary members of the ruling Georgian Dream coalition. Criticism was also particularly directed against the head of the National Bank, Mr. Giorgi Kadagidze. Members of the ruling party then introduced a legislative initiative in parliament to remove the banking sector supervisory functions from the National Bank, and give these functions to a newly-established, independent legal entity. This move limits the central bank’s independence.
The question of a central bank’s independence was actively debated by scholars in the 1990s. Research (e.g. Cukierman A. 1992) proved that “under dependent central bankers, private investments are lower, reducing the long run rate of growth.” Other research later confirmed that the independence of the central bank helps to lower inflation.
If a government can credibly guarantee the independence of the central bank, then expectations in long-term inflation are reduced. It therefore takes less social cost to keep inflation down, promotes investment, and supports long-term economic growth. When long-term expectations are secure, short-term economic conditions improve. If the government cannot guarantee the independence of the central bank, it can be argued that it is better for society to take monetary policy out of the government’s hands.
"We need to protect [the] independence of the central bank; they are doing a good job… I think that political attacks are not the best way forward in this difficult time"
The independence of the central bank becomes more important during times of economic stress. Since the 2008 financial crisis, there are a number of country examples where there was pressure on the central bank (Greece, Turkey, Hungary, etc). So it was in Georgia as well. Due to external shocks, triggered by the appreciation of the U.S. Dollar and regional political tensions, Current Account revenues started to decline.
Exports and remittances declined by 20-25%, while imports continued to grow, widening the current account imbalance. Given that FDI was weak, the adjustment of the exchange rate was inevitable. Under the Current Account shock, the prudent policy is to smoothen the adjustment process in the short run and try to increase foreign exchange (FX) revenues in the medium run. Despite this, the government has chosen to politicize the exchange rate adjustment and use this opportunity to attack the central bank governor, in order to restrain the NBG’s independence. An attack was politically appealing, rather than having to explain the reasons for the depreciation of the national currency and rather than have to take action in regards to ease lending burden for borrowers in FX.
The IMF was very vocal in supporting the NBG and condemning the political attack. The head of the IMF mission in Georgia said: “We need to protect [the] independence of the central bank; they are doing a good job… I think that political attacks are not the best way forward in this difficult time.”
The European Bank for Reconstruction and Development conveyed the same message. EBRD president, Sir Suma Chakrabarti, said: “The approach of the Central Bank should be applauded; allowing the exchange rate to float protects the central bank reserves, which are very important for protecting the country as a whole. So, in my view the central bank is doing an excellent job. I think its independences is fundamental; it’s fundamental for the short term, medium, and long term confidence for outsiders, investors in this economy.”
The NBG was able to lower household loan dollarization from 75% to less than 50% in volume terms, and less than 10% in the number of borrowers in the banking sector. However, the dollarization rate for non-bank lenders are much higher, which makes the GEL/USD exchange rate a politically sensitive issue. Due to their low level of financial knowledge, politicians were demanding from the NBG to take action to strengthen the GEL. But the actions they were demanding were aimed at a very short term appreciation of the GEL, that would a few months later result in a large depreciation, severe recession and unemployment growth, lower budget revenues, and increased social and political problems. The demanded actions on the NBG were to massively sell FX reserves, to generate a GEL liquidity shock for the banks, to dramatically increase interest rates, etc. It was clear -- maybe not for politicians -- that the negative effect of such policies would largely overweight possible short-term benefits.
The NBG itself has followed prudent policies. It has limited interventions in order to avoid excessive volatility where possible. The IMF, World bank, and EBRD have praised the NBG’s policy response during this time of stress, and have commended NBG president Mr. Kadagidze for successfully implementing inflation targeting in Georgia and for managing to lower inflation.
Despite pressures, the NBG’s independence was sufficient to resist political forces; therefore the government decided to weaken the NBG’s independence by taking control over the central bank’s main transition channel—the banking system. In July, Parliament adopted the law separating banking supervision from the NBG. The new agency which will be in charge of banking supervision will have less independence, as it will be possible to remove the head, who has the sole decision-making power.
The board will be appointed by the government and approved by the parliament; there is no transparency in choosing the candidates in the law. There will be no checks and balances in the appointment process, as the government has a majority in the parliament. It is evident that the new institutional setup will deteriorate banking supervisory quality in Georgia, which was regarded as exemplary for the region.
The president of the EBRD, Sir Suma Chakrabarti, had earlier said: “The level of banking sector development in Georgia is sufficiently high, and what is very important, it is stable. The banking system of Georgia is distinguished from all other countries’ banking systems where we work. The banking sector is sound and stable; therefore it is no wonder that the customers have a confidence in banks.”
NBG Mr. Kadagidze was praised by international media for achieving tangible results and maintaining prudent policies, despite political pressure on him. World-leading financial magazine The Banker, owned by The Financial Times Group, named Giorgi Kadagidze as the 2014 Central Banker of the year for Europe.
There was an unprecedented reaction to the move to strip the NBG’s supervisory functions when four large international financial institutions (IFI) -- the World Bank, IMF, EBRD, and Asian Development Bank -- “expressed deep concern” in a joint letter addressed to the prime minister of Georgia about it. Their main advice was to not separate the banking supervision from the NBG. The IFIs had four major points: It is not a prudent decision and goes against best practice and recent trends; separating the supervisory functions will damage the independence of the supervisory body; it will lower the quality of banking supervision; the process itself is not in line of the best practice, and given certain macroeconomic challenges, the timing for the changes are not suitable.
"The level of banking sector development in Georgia is sufficiently high, and what is very important, it is stable. The banking system of Georgia is distinguished from all other countries’ banking systems where we work. The banking sector is sound and stable; therefore it is no wonder that the customers have a confidence in banks"
The government held informal consultations with the IMF and received comments from the Fund. The day before the third hearing on the proposed bill in parliament, the IMF voiced a strong negative position on the law. In an interview to Maestro TV, the IMF representative in Georgia said that: “The IMF’s recommendation is to leave banking supervision at the NBG is unchanged… The IMF has not yet received arguments justifying the separation.”
A few days later, the prime minister and Vice-PM said that: “All comments and suggestions from the IMF have been fully incorporated in the final version of the law.” The resident representative of the IMF responded that their fundamental recommendations have not been addressed; the proposed process creates risk to financial stability; it’s not in line with the IMF’s polices, and therefore jeopardize the Fund’s program.
Despite such unprecedented strong opposition, from opposition parties, civil society groups, and IFIs, the process is moving forward. Given the potential damages it will bring to the economy, President Margvelashvili vetoed the law. The parliament overcome the presidential veto in early September, and went forward with the formation of the new supervisory agency. Two leading opposition parties, the UNM and Free Democrats, have appealed this law and the constitutional court suspended it.